I'm Political Economy editor at Forbes, editor of RealClearMarkets.com, plus a senior economic advisor to Toreador Research & Trading. I have book on how the economy works, Popular Economics: What LeBron James, the Rolling Stones and Downton Abbey Can Teach You About Economics that is set for release in April of 2015. I have a weekly column on Mondays at Forbes.com.

Obama's Order To Hike Federal Wages Will Lay A Wet Blanket On Small Businesses

President Obama’s State of the Union announcement that he’ll sign an executive order increasing the minimum worker wage for federal contracts from $7.25/hour to $10.10 drew warm applause. This was interesting considering an earlier applause line from the President in which he said “Let’s do more to help the entrepreneurs and small business owners who create most new jobs in America.”

The President’s plan to hike federal wages will harm the private entrepreneurial economy for luring more workers into federal employ. And it will erect yet another barrier to small business formation.

To understand why, it’s useful to get back to the basics of economics. The federal government has no resources, by definition. It’s only able to spend, and in this case raise federal contract wages, insofar as it taxes or borrows that money from the private economy.

Importantly, it can do both with ease. Even in its relatively depressed state, the U.S. economy is comprised of the most productive and dynamic individuals and companies in the world. We have a capital account surplus, or a “trade deficit” precisely because investors around the world still feel the U.S. is one of the best places to park growth capital.

All of this is important in light of President Obama’s decision due to the reality that our federal government has within reasonable limits unlimited funds to spend. President Obama can offer higher wages in federal contracts with certainty, and he can because his ‘generous’ with the money-of-others executive orders are backed by federal taxing and borrowing power collateralized by the world’s largest economy.

What must be stressed first is that this is bad for the small businesses that he claims to support. To see why, it’s worth remembering what’s a blinding glimpse of the obvious: small businesses pay federal taxes either through the corporate tax, or through taxation of the individuals who own them.

Small businesses and their owners will pay taxes that the federal government will then use to bid for workers against them. If federal contracts can offer a higher minimum wage for workers, it means that small businesses, having funded the federal government’s largesse, will also in the bargain have to offer higher wages themselves in order to compete for workers. In short, small businesses will give the federal government the resources to raise their costs.

The logical reply to the above might be that this scenario is to the benefit of all concerned. If an executive order from President Obama that raises federal wages similarly forces small businesses to pay more, public and private workers will be made better off. It all seems so simple, but it only is if readers fail to take the federal wage hike to its logical conclusion.

There are no private companies, and there are no jobs, without investment first. For a business to open its doors, someone somewhere must delay consumption such that businesses can access their savings or investment. Importantly for those investors and savers whose non-consumption creates businesses and jobs, they delay their consumption if they feel they can get a return on their investment. Profits are their return.

But if the federal government is using the money of taxpayers to pay its workers more, and if higher federal wages mean that small businesses have to follow suit, simple logic dictates that profits for smaller businesses will shrink. As it is their margins are thin, and if President Obama’s “compassion” with money not his own raises operating costs for private businesses, profits in those same businesses will decline.

If so, as in if President Obama’s executive decision forces the wage structure upward, the profits that attract investors will be less appealing. In that case small business formation will on the margin shrink amid rising federal spending.

Considering low-wage workers, some might disregard President Obama’s executive order and assert that as these are tough times, it’s good that federal pay is increasing. In that case, it will be better for the lowest earners to work in government over the less generous entry-level wages offered in the private sector. That’s fine as it goes, but it ignores the longer term potential of private sector employment.

Indeed, italicized in the previous paragraph is ‘entry level’ wages. Though the media and politicians focus relentlessly on the low wages offered to entry level workers, what they leave out is that while the pay at McDonald’s and Walmart is surely low in the initial stages, both employers can point to workers who, though they started at the bottom, are now store managers, owners of McDonald’s franchises, and executives for McDonald’s and Walmart at the headquarters of each commercial giant.

No doubt the federal government, always using funds extracted from the private sector, can offer better entry level pay, and to varying degrees, good salaries for their high-level workers. But there’s a limit. Ultimately, private sector work pays better for those who stick it out.

(Photo credit: Wikipedia)

So while entry-level workers may well migrate toward the higher wages President Obama has mandated with money not his own, ultimately doing so will prove a bad bargain for the very individuals Obama presumes to help. That is so simply because the long-term earning potential of a successful private sector worker is much greater, but the potential is mostly there for the individuals willing to start at the bottom. Higher entry level federal pay will only succeed insofar as it lures workers into the non-productivity that defines government work, and that renders them unsuited for the real, market-disciplined work that can with time offer true economic advancement.

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